11/28/2016 Course 10 Embedded Options and Volatility – Understanding Callable Bonds and Prepayments Government Investment Officers Association 0 Lessons and Learning Objectives Course Description Recognize how the embedded option in callable bonds impacts yields and prepayment risk. Consider the impact of embedded options on standard risk factors associated with bonds: interest rate risk, reinvestment risk, call risk, default (credit) risk. Lessons and Learning Objectives 1. Option(s) Defined 2. Volatility Defined 3. Callable Bonds a) What is it? b) Why is it? 4. Analyzing Callable Bonds a) Yield Spread Analysis b) Option Adjusted Spread Analysis 5. Considerations a) Big Picture b) Just One Tool Government Investment Officers Association 1 1 11/28/2016 Philosophy, Strategy & Tactics Investment Philosophy is a coherent way of A plan of action or policy thinking about markets designed to achieve one (how they work), Philosophy or more goals usually efficiency, risk, return under conditions of & Investor Behavior. uncertainty. Resources, skills Tactics Strategy and methods used The intersection of to achieve or Philosophy, Strategy advance the goal & Tactics is the of a strategy. world of Portfolio The difference between strategy and tactics: Strategy Management. is done above the shoulders, Tactics are done below the shoulders. Government Investment Officers Association 2 What is an Option? OPTION, n. The right to buy or sell a financial asset at a fixed price on or before a specific time, from the Latin optio, “I choose”; a boon for stockbrokers whose clients don’t understand how options work and generate a fortune in commissions as they attempt to learn. Explained Hugh Askin-Mee, a client of the brokerage firm Bourne, Rich & Howe: “I put two children through Harvard by trading options. Unfortunately, they were my broker’s children.” Perhaps the earliest recorded options trade, according to Aristotle, was made by Thales of Miletus (ca. 624– 547 BC), one of the “Seven Sages of Greece,” who put down deposits on all nearby olive-oil presses one winter when his knowledge of astronomy purportedly told him that the next year would bring a good olive crop. Thales paid almost nothing and profited hugely when the abundant harvest created high demand for presses— thus making him one of the first individual investors to make more money trading options than his brokers did. He was also one of the last.(1) (1) Zweig, Jason. The Devil's Financial Dictionary (pp. 147-148). Kindle Edition. Government Investment Officers Association 3 2 11/28/2016 What is Volatility? VOLATILITY, n. The extent to which an investment’s short-term returns differ from its long-term average returns, technically known as standard deviation and colloquially known as Oh my God! When an investment has been making money, the people who own it say that they are comfortable with volatility. When it starts losing money, they suddenly will declare that they hate volatility. The investment hasn’t changed; only their perceptions have. The most volatile element in financial markets is investors’ own views of volatility. (1) (1) Zweig, Jason. The Devil's Financial Dictionary (pp. 223-224). Kindle Edition. Government Investment Officers Association 4 Callable Bonds: What is it? • A bond where the issuer has the option to call (buyback) the bond from an investor at a pre-determined price on a pre- specified date. • The option to call the bond is usually one of the following kind: o European: One time only o Bermudan: Multiple times quarterly or semi-annually usually on coupon payment dates o American: Any time after a specified date • In return for the option to call, the issuer pays a higher coupon than a non-callable bond of similar maturity. • The value of the call option depends on: o How often and at what price the issuer can call the bond (exercise option) o Time to the call date o Volatility of interest rates Government Investment Officers Association 5 3 11/28/2016 Callable Bonds: Nomenclature Government Investment Officers Association 6 Callable Bonds: Nomenclature Government Investment Officers Association 7 4 11/28/2016 Callable Bonds: Data • FHLMC (Freddie Mac) Bond Data: http://www.freddiemac.com/debt/html/sactivitymain.html • FNMA (Fannie Mae) Bond Data: http://www.fanniemae.com/portal/funding-the- market/debt/reports/ • FHLB (Federal Home Lone Bank) Bond Data: http://www.fhlb-of.com/ofweb_userWeb/pageBuilder/debt- securities-21 • FFCB (Federal Farm Credit Bank) Bond Data: https://www.farmcreditfunding.com/ffcb_live/activitySummary.ht ml • FRB (Federal Reserve Bank) Call Notices: https://www.frbservices.org/app/callnotices/CallNotices.action • TRACE (FINRA Trade Reporting and Compliance Engine): http://finra-markets.morningstar.com/BondCenter/Default.jsp Government Investment Officers Association 8 Callable Bonds: Why is it? • Agencies buy mortgage loans and assets backed by mortgage loans. • Home owners usually have the right to pre-pay the mortgage loan at any time: o When rates drop home owners are likely to pre-pay loans and “re- finance” at lower rates. o When rates rise home owners are likely to keep the low rate loan rather “re-finance” with a higher rate loan. • Therefore, Agencies are short options to homeowners • The issuance of callable bonds allows the Agencies to match the characteristics of the mortgage loan (asset/liability management): o When interest rates drop, mortgage loans (assets) pre-pay, Agencies can redeem their callable bonds (liabilities). Government Investment Officers Association 9 5 11/28/2016 What are Primary Risks with Bonds • Interest Rate Risk: The risk that bond prices will fall as interest rates rise. • Reinvestment Risk: The risk that proceeds from the bond will be reinvested at a rate lower than the yield when purchased. • Call Risk: The risk that a bond with a call provision will be called (redeemed before the stated maturity date) by the issuer. • Default/Credit Risk: The risk that the bond issuer will be unable to pay the interest and principal as promised. Government Investment Officers Association 10 Analyzing Bonds: Yield Spread “Given that Treasury securities do not expose investors to credit risk, market participants look at the yield offered on an on-the- run Treasury security as the minimum interest rate required on a non-Treasury security with the same maturity. … it is commonplace to refer to the additional yield over the benchmark Treasury issue of the same maturity as the yield spread. yield spread = yield on bond X - yield on bond Y where bond Y is considered the reference bond (or benchmark) against which bond X is measured. When a yield spread is computed in this manner it is referred to as an absolute yield spread and it is measured in basis points.” [Fabozzi CFA, Frank J. (2010-05-13). Fixed Income Analysis (CFA Institute Investment Series) (Kindle Locations 1590-1591, 1673, 1676-1678). Wiley. Kindle Edition] Government Investment Officers Association 11 6 11/28/2016 Yield Spread: Agency Bullet(s) Agency Bullet Yield Curve Treasury Yield Curve Agency Bullet Spread Government Investment Officers Association 12 Yield Spread: Agency Callable(s) Agency Callable Yield Curve Treasury Yield Curve Agency Callable Spread Government Investment Officers Association 13 7 11/28/2016 Yield Spread: Tsy-Bullet-Callable Agency Callable Yield Curve Agency Bullet Yield Curve Treasury Yield Curve Agency Callable Spread Government Investment Officers Association 14 Yield Spread: Problem/Solution “Since callable bonds have more than one possible redemption date (their call dates and maturity), the collection of future cash flows contributing to their overall return is not clearly defined. … an issue’s incremental risks are evaluated relative to its incremental return. When the return measure itself is flawed, the possibility of drawing catastrophically incorrect conclusions about risk and return becomes very real. … A more complete measure of return should fulfill the following requirements: 1. It should account for the risks posed by an uncertain redemption date by providing an objective measure of performance that is independent of any assumed redemption date. 2. It should provide a means of assessing the incremental return contained in the security relative to a riskless benchmark.” [(2010-05-18). Introduction to Option-Adjusted Spread Analysis (Bloomberg Financial) (Kindle Locations 227-228, 240-242, 281-285). Wiley. Kindle Edition.] Government Investment Officers Association 15 8 11/28/2016 Spread Analysis: Two Approaches Yield Spread Analysis: Usually quoted in basis points (1/100th of 1%) by subtracting a benchmark bond yield (usually a US Treasury of similar maturity) from the yield of the bond being analyzed. The spread represents the incremental return over the benchmark the investor earns for taking on Interest Rate Risk, Reinvestment Risk, Call Risk and Credit Risk. This incremental return is to a specific date (usually maturity) and does not take into account the possibility of an early redemption. Government Investment Officers Association 16 Spread Analysis: Two Approaches Option Adjusted Spread Analysis: A financial-analysis method that analyzes the impact of any options embedded in a bond’s structure and measures the issue’s expected incremental return. Quoted in basis points, the OAS represents the constant spread applied to the benchmark rates in a fixed-income option model to recover the price of the bond being analyzed. The measure is called OAS because (1) it is a spread and (2) it adjusts the cash flows